Let’s address a situation where the mortgage or debt on your replacement property is lower than the mortgage or debt you had on your relinquished property, what would happen then?
Before diving deeper into the above situation, it is important to understand what is “boot”. Boot refers to any “left over” proceeds from the sale of a relinquished property that are not reinvested into the replacement property. The said funds are taxable and must be reported at the end of the year.
When it comes down to debt, it’s called mortgage boot or debt reduction, let’s say you have your relinquished property that you sold in Houston, Texas for $500,000.00 with a debt of $300,000.00, which leaves you $200,000.00 in your proceeds and then you purchased your replacement property in the amount of $600,000.00 and use $400,000.00 of cash and the remaining $200,000.00 as a bank loan. Your debt on your replacement property is $100,000.00 less than the one on your relinquished property, even though all your proceeds are fully invested into the replacement property, the IRS will consider the $100,000.00 difference in the debt values as taxable, even though it is not actual cash coming in your pocket.
The taxation on the said debt boot will work as follows, if the relinquished property was held for less than a year, the debt boot will be taxed at ordinary income tax rates. Conversely, if the property was held for over a year, the boot will be taxed at long-term capital gain tax rates which range from 0% to 20%, which are generally lower.
Now if you decided to purchase the above-mentioned replacement property all in cash and not use any debt, then you would not have to worry about debt boot given that you used cash to replace the debt.
To be in compliance with these rules and ensure a successful 1031 exchange, it is advisable to consult with your CPA and/or tax attorney given that everyone’s tax and financial situation is different.